Legislators weigh fiscal cliff stopgap measures

House Republicans are unlikely to win substantial reductions in government spending during the fiscal cliff negotiations. But observers say the current talks could lead to an “bridge” agreement that heads off a massive tax hike and automatic spending cuts scheduled for January, leaving open the possibility of revisiting comprehensive fiscal reform next year.

“There’s an 80 percent probability that we will get through to 2013, with a framework for long-term fiscal reform,” economist Douglas Holtz-Eakin, president of the American Action Forum and former director of the Congressional Budget Office, said in an interview.

The negotiations between President Obama and GOP leaders, which began last week and will continue through the end of this year, aim to avoid a combination of expiring tax limitations and budget “sequestration” that would cap discretionary spending, both of which are set to kick in Jan. 1, 2013.

What form the stopgap could take is a matter of intense debate, but one thing seems certain: Taxes are going up. Obama has been pitching a “balanced approach” that asks “the wealthiest Americans to pay a little more in taxes.”

Meanwhile, House leaders, including Speaker John Boehner (R-Ohio) and Majority Leader Eric Cantor (R-Va.), have signaled their willingness to compromise on tax issues. “For purposes of forging a bipartisan agreement that begins to solve the problem,” Boehner said at a press conference after the election, “we’re willing to accept new revenue, under the right conditions.”

Cap on tax deductions?

One proposal, which could resolve these two positions, is a cap on tax deductions, an idea Republican challenger Mitt Romney floated during his presidential campaign. Under this proposal, taxpayers would be limited in the amount of total deductions they could claim, with suggested caps of $17,000 or $35,000. Obama has suggested a cap of 28 percent of income.

The deduction cap has several advantages. It could avoid a hike in marginal rates, and it applies primarily to higher earners, who make the most use of tax deductions. And by applying a solid cap without specifying deduction types, this proposal could avoid a backlash from special interests.

“The beauty of a cap on total deductions is that you don’t have to pick among those interests,” said Holtz-Eakin. “Politically it’s a very clever proposal.”

It could also bring some economic benefit, according to Rep. Tom McClintock (R-Calif.), who serves on the House Budget Committee. “I would support [a deduction cap] provided tax rates are lowered by a commensurate amount,” McClintock said in an interview. “That would create additional revenue through economic activity. But if the cap on deductions is merely to gain more revenue, that’s not going to work, and it could make the economy worse.”

But Republicans are hamstrung by several political factors in their talks with the president. While the GOP maintains a majority in the House, it lost seats in both houses of Congress in the Nov. 6 election.

Obama is also eager to claim a mandate from the vote. The president held a high-profile meeting last Tuesday with labor leaders, urging them to support his plan for a $1.6 trillion tax hike on top earners over the next decade. “We’re prepared to stand up to make sure there is shared sacrifice here, so the rich actually start paying their fair share and the middle class don’t get soaked for that,” AFL-CIO President Richard Trumka said in a press conference after that meeting. In general, the president’s labor allies oppose most or all spending cuts.

Dems favor tax rate increases

Other Democrats are intent on tax rate increases rather than a deduction cap. “The president and Senate Democrats have put forward concrete plans to generate revenue from the most wealthy,” Sen. Patty Murray (D-Wash.), who is set to chair the Senate Budget Committee, said in an email. “I have yet to see a proposal from Republicans that adds up to the type of revenue we will need while keeping the tax code progressive.”

Public opinion also appears to be against the Republicans. In a recent Washington Post-Pew Research Center survey, 53 percent of respondents said Republicans “would be more to blame” if no agreement were reached, while only 29 percent would blame the president.

The biggest danger of the fiscal cliff is tax increases, not spending cuts. The 2011 Budget Control Act cuts spending by about $100 billion per year, but these cuts would apply to a baseline that assumes spending growth at the rate of inflation per year. Because many government functions (including Social Security and Medicare) are protected from sequestration, the cuts fall primarily on core government functions, with some items, including defense, facing 8 percent or 9 percent reductions.

Focus on provisional tax treatments

More importantly, various provisional tax treatments are expiring. These include the 2002-2003 tax rates, the alternative minimum tax (AMT) “patch” that spares about 26 million Americans from paying the AMT, a payroll tax holiday that reduces an employee’s share of Social Security taxes by about two percentage points, and a variety of “tax extenders” that apply to charitable giving and other areas.

A September report by Congressional Research Service estimates that the expiration of these provisions would suck $5.4 trillion out of the economy over 10 years. “The impact of a tax increase on a brittle economy is well documented,” McClintock said.

While there is broad bipartisan support for ending the payroll tax holiday, other tax provisions are up for grabs, and many Democrats’ constituents like some of these reductions (in particular the AMT patch). While that makes compromise possible, the harder fiscal work, including a comprehensive reform of entitlements, would remain for next year.

“If we could get serious debate on the structure of government, we could get back to a better balance between government and private sector,” said Jade West, a senior vice president at the National Association of Wholesalers who manages the Washington business group Tax Relief Coalition. “But you’re not going to have that debate in December.”